Copyright 2018 Mitul Kotecha

The market mood has definitely soured and risk appetite has faltered. This is good for the USD but bad for relatively high yielding/commodity risk trades. The USD is set to retain a firm tone over the near term even if is temporary, which I believe it is.

Whether it’s profit taking on crowded risk trades, a lot of good news having already been priced in, fears that other countries will follow Brazil’s example of taxing capital inflows to dampen currency strength, or a reaction to weaker economic data, it is clear that there are many reasons to be cautious.

It is also unlikely to be coincidental that the rise in risk aversion and drop in equity markets is happening at a time when many central banks are contemplating exit strategies and when many investors are pondering the timing of interest rates hikes globally following the moves by Australia and Israel.

One of the reasons for the worsening in market mood is that some parts of the global economy may not be ready for rate hikes. Certainly there is little chance of a US rate hike on the horizon and perhaps not until 2011 given the prospects of a sub par economic recovery. This projection was given support by the surprise drop in US consumer confidence in October.

It is not just the US that is unlikely to see a quick reversal in monetary policy. As indicated by the bigger than expected decline in annual M3 money supply growth in the eurozone, which hit its lowest level since the series began in 1980, as well as the drop in bank loans to the private sector, the ECB will be in no hurry to wind down its non-standard monetary policy measures.

The chances of any shift in policy at next week’s ECB meeting are minimal, with the ECB’s cautious stance emboldened by the subdued money supply and credit data. As long as EUR/USD remains below 1.50 ECB President Trichet is also unlikely to step up his rhetoric on the strength of the EUR.

Although the major economies of US, Eurozone, Japan and UK are likely to maintain current policies for a long while yet, the stance is not shared elsewhere. The Reserve Bank of India did not raise interest rates following its meeting this week but edged in this direction by requiring banks to buy more T-bills. Other central banks in the region are set to move in this direction.

In terms of developed economies, Norway was the latest to join the club hiking rates by 25bps and adding to the growing list of countries starting the process of policy normalisation. Australia is set to hike rates again at next week’s meeting although a 50bps hike looks unlikely, with a 25bps move more likely.

Markets are increasingly discounting stronger than expected Q3 earnings. Further gains in equities and risk appetite may be harder to achieve even if profits continue to be beat expectations, which so far around 80% of Q3 earnings have managed to do. Measures of risk such as the VIX “fear gauge” have highlighted an increasingly risk averse environment into this week. The negative market tone could continue in the short term.

The USD has found some tentative relief, helped by the drop in equities and profit taking on risk trades. The fact that the market had become increasingly short USDs as reflected in the latest CFTC Commitment of Traders’ (IMM) report in which aggregate short USD positions increased in the latest week (short USD positions numbered roughly twice the number of long positions), has given plenty of scope for some short covering this week.

The USD has even managed quite convincingly to shake off yet another article on the diversification of USD reserves in China. The USD index looks set to consolidate its gains over the short term against the background of an up tick in risk aversion. The USD index will likely remain supported ahead of the main US release this week, Q3 GDP on Thursday, but any rally in the USD is unlikely to be sustainable and will only provide better levels to short the currency.

Given the broad based nature of the reversal in risk sentiment with not only equities dropping but commodities sliding too, it suggests that high beta currencies, those with the highest sensitivity to risk will suffer in the short term. These include in order of correlation with the VIX index over the past month, from the most to the least sensitive, MXN, AUD, MYR, SGD, NOK, EUR, CAD, INR, ZAR, BRL, TRY and NZD. The main beneficiary according to recent correlation is the USD.

EUR sentiment in particular appears to be weakening at least on the margin as reflected in the latest IMM report which revealed that net long EUR speculative positions have fallen to their lowest level in 6-weeks. Whether this is due to profit taking as EUR/USD hit 1.50 or realisation that the currency appeared to have gone too far too quickly, the EUR stands on shakier ground this week. EUR/USD may pull back to near term technical support around 1.4840 and then 1.4725 before long positions are re-established.

Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil. The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.

The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows. The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.

Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact. Previous such measures have done little to prevent further appreciation. The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”.

At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning. The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction.

Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction. In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.

The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared.

Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil. Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle.

It seemed inevitable and finally after flirting with the 1.50 level, EUR/USD managed to break through although there seems to be little momentum in the move, with the currency pair dipping back below 1.50 in the Asian trading session. Contrary to expectations the break above 1.50 did not lead to a sharp stop loss driven move higher.

Even the break through 1.50 only provoked a limited reaction in the FX options market where implied EUR/USD volatility only moved slightly higher. In fact despite the warnings by ECB President Trichet about “excessive currency volatility” FX options volatility for most currency pairs has been on a downward trajectory over the past few months, implying that the move in EUR/USD and the USD itself has been quite orderly.

Trichet’s warning is more likely a veiled threat on the level of EUR/USD rather than its volatility, unless of course the ECB chief is seeing something that the FX options market is not. Assuming that EUR/USD closes above 1.50 this week it technically has plenty of open ground on the run up to the record high of 1.6038 hit in July 2008 but there will also be plenty of official resistance to limit its appreciation. Such resistance is limited to rhetoric but it will not be long before markets begin discussing the prospects of actual FX intervention.

GBP was helped by relief that the minutes of the BoE meeting showed no inclination to increase the level of quantitative easing despite the ongoing debate within the MPC. The minutes even sounded slightly upbeat about economic prospects. GBP/USD hit a high of 1.6638 in the wake of these developments due in large part to more short covering whilst EUR/GBP briefly dipped below 0.90. GBP/USD may find it tough going to make much headway above 1.66 as has been the case over recent months, with strong resistance seen around 1.6661.

Although there appears to be some consolidation at present the USD remains on a steady downward path and is likely to continue to face a combination of both cyclical and structural negative forces. Cyclical pressure will come from the extremely easy monetary policy stance of the Fed as well as the ongoing improvement in risk appetite. The structural pressure on the USD continues to come from the diversification of new FX reserve flows (mainly from Asian central banks) as well as concerns about the reserve value of the USD in the wake of massive US fiscal and monetary stimulus.

Although risk aversion is no longer as correlated with the USD as it was a few months ago there is no doubt that the USD is still highly sensitive to equity market movements. Correlations between the USD index and the S&P 500 are consistently high (and negative) over 1M, 3M and 6M time periods. The relationship reveals just how closely the fortunes of the USD are tied to the gyrations in equity markets.

Much will therefore depend on the shape of US Q3 earnings. The fact that the majority of earnings released so far have beaten expectations has provided equities with more fuel whilst the USD has come under greater pressure. Should as is likely the trend in earnings continue to beat forecasts the USD is likely to weaken further, pushing through key resistance levels. In particular, a sustained break above EUR/USD 1.50 could see a swift move substantially higher, with little in the way of technical resistance on the way up to 1.60

The real test will come when the lofty expectations for economic recovery match the reality of only sub-par growth in the months ahead. In the meantime, the firmer tone to global equity markets may encourage capital outflows from the US into foreign markets by investors who had repatriated huge amounts of capital during the crisis.

As risk appetite improves, the hunt for yield will intensify. The USD has easily taken over the mantle from the JPY as funding currency of choice for investors, pointing to further pressure on the USD. The timing of monetary policy reversal in the US will be crucial for the USD but it is highly unlikely that the Fed will hike rates next year.

The majority of US Q3 earnings have beaten market expectations resulting in a boost to risk appetite and further pressure on the US dollar. At the time of writing, 61 companies have reported earnings in the S&P 500 and an impressive 79% have beaten forecasts according to Thomson Reuters. This week there are plenty of earnings on tap and although a lot of positive news appears to be priced in the overall tone to risk appetite remains positive. This implies a weaker US dollar bias given the strong negative correlation between US equities and the USD index.

Aside from the plethora of earnings there are plenty of data releases on tap this week including housing data in the US in the form of building permits and starts as well as existing home sales. The data will likely maintain the message of housing market stabilisation and recovery in the US. There will also be plenty of Fed speakers this week and markets will once again scrutinize the speeches to determine the Fed’s exit strategy.

Highlights this week also include interest rate decisions in Canada and Sweden. Both the BoC and Riksbank to leave policy unchanged and expect a further improvement in the German IFO in October though at a more gradual pace than in recent months. There will be plenty of interest in the UK MPC minutes given conflicting comments from officials about extending quantitative easing. RBA minutes will be looked at for the opposite reason, to determine how quickly the Bank will raise interest rates again.

The USD index managed a slight rebound at the end of last week but is likely to remain under pressure unless earnings disappoint over coming days. US dollar Speculative sentiment became more bearish last week according to the CFTC IMM data, with dollar bloc currencies including the AUD, NZD and CAD benefiting the most in terms of an increase in speculative appetite. GBP short positions increased to a new record but the rally towards the end of last week may have seen some of these short positions being covered. Overall any recovery in the USD this week may just provide better levels to go short.

Risk was firmly back on over the past few days as the majority of earnings came in stronger than expected; around 80% of S&P 500 companies have beaten expectations so far. Data releases in the US have also continued to beat forecasts, the latest of which was the September industrial production report. The dollar stood little chance of a recovering against this background and continues to languish around 14-month lows.

Sterling has been the star performer, perhaps a reflection of the fact that the market was extremely short (CTFC IMM data revealed record net short sterling positions last week) and some hints that the Bank of England may not extend quantitative easing was sufficient to provoke a short covering rally. Still the pound’s gains may prove short-lived until there are clearer signs of economic recovery and of a turn in the interest rate cycle.

There will be some key events and data over the coming week that will give further direction to sterling including a speech by BoE Governor King, MPC minutes, retail sales and preliminary Q3 GDP data. Overall, the data are unlikely to deliver much of a boost to the pound even though both retail sales and GDP are likely to deliver positive readings. Sentiment for the pound continues to swing in a wide range and though a lot of negativity was in the price a sustained recovery is far off. The risks remain that GBP/USD will push back towards support around 1.5902.

I still believe that there is little positive to be said for the euro too. The currency benefits from a weaker dollar but is hardly supported by fundamentals especially as a stronger euro damages one of the main engines of eurozone growth, namely exports. EUR/USD will struggle to make headway through 1.50 though once through here it could easily be carried higher. The most positive factor supporting the euro is the continued recycling of central bank intervention flows here in Asia and this may be sufficient to propel EUR/USD through 1.50 before hitting a wall of resistance around 1.5084.

The dollar itself may be given a lifeline from what looks like a softer tone to markets at the end of the week but overall sentiment remains very bearish despite attempts by various US officials to talk the dollar higher this week. The Fed’s Fisher hit the nail on the head when he said that the dollar’s long term value depends on policymakers “getting it right”. In the short term however, it’s all about risk and increasingly it will be about interest rate differentials, both of which will play negatively for the dollar.

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